Profiting from inflation

For consumers, inflation means higher prices on goods and services, and a loss of purchasing power if their income fails to keep up. For investors, it means moving some of their money to assets that benefit from inflation or at least keep up with its pace.

Persistent deflation can increase unemployment and undermine the financial system as well as the broader economy by making it more difficult to service debt. The U.S. Federal Reserve is targeting a 2% average inflation rate over time as most consistent with its dual mandate to promote price stability and maximum employment. Sharp deviations from a modest inflation rate in either direction present challenges for investors as well as consumers. That’s because they have the potential for significant economic disruption. They also have varying and often unpredictable effects on various asset classes.

In economics, inflation is a quantitative measure—one of quantity over quality—tracking the rate of change in prices of a standardized basket of goods. Inflation is defined as an increase in prices over time, and the rate of that increase is expressed as a percentage.

The most common economic reports used to measure inflation are the Consumer Price Index (CPI), the Producer Price Index (PPI), and the Personal Consumption Expenditures Price Index. The PCE Price Index is the Federal Reserve’s preferred inflation gauge.

The PCE is a broader measure than the CPI and is weighted based on consumption measures used to derive the gross domestic product rather than on a household spending survey as the CPI.

While inflation’s effects on the economy and asset values can be unpredictable, history and economics offer some rules of thumb,

Inflation is most damaging to the value of fixed-rate debt securities, because it devalues interest rate payments as well repayments of principal. If the inflation rate exceeds the interest rate, lenders are in effect losing money after adjusting for inflation. This is why investors sometimes focus on the real interest rate, derived by subtracting the inflation rate from the nominal interest rate.

Longer-term fixed rate debt is more vulnerable to inflation than short-term debt, because the effect of inflation on the value of future repayments is correspondingly greater, and compounds over time.

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